Nothing gets strategists buzzing quite like a close election. True to form, they’ve served up heaps of forecasts around Italy’s big vote that occurred Sunday.

The Italian election produced no clear winner, but showed a surge in support for anti-establishment parties. The euro zone’s third-largest economy appears to be facing a period of uncertainty as the parties try to hammer out a coalition deal.

There had been five possible outcomes, reckoned Silvia Dall’Angelo, a senior economist at Hermes Investment Management, in a note before the vote: (1.) Political gridlock followed by another election; (2.) a victory for a center-right alliance of parties; (3.) a center-left coalition government; (4.) a government led by the antiestablishment 5 Star Movement; or (5.) a grand coalition. Each has had an anticipated impact on European stocks.

Dall’Angelo stressed that Italy is accustomed to political instability, with 65 administrations since World War II, “each one lasting for a little more than a year on average.”

The most likely scenario

The most likely outcome had looked like some sort of coalition government with a weak mandate, according to Dall’Angelo and other election watchers. Scenarios 1, 2, and 3 mentioned above each would have delivered that—at least eventually.

Strategists have suggested markets could live with this type of outcome, as well as with uncertainty about how negotiations will turn out. Italy’s FTSE MIB benchmark
XX:I945
was recently down about 1% in Monday trade.

“Difficult post-election negotiations are the norm nowadays, as seen with the prolonged attempt to form a government in Germany,” wrote Konstantinos Anthis, head of research at ADS Securities, in an email to Barron’s.

The worst-case scenario for stocks

The worst-case scenario for equity markets—mostly Italy’s—would be an anti-euro coalition government comprised of the 5 Star Movement and the populist Northern League and Brothers of Italy parties, said Seema Shah, an investment strategist at Principal Global Investors. She had viewed that outcome as a remote possibility, and she emphasized the recent shifts by the 5 Star Movement.

“There has been a lot of focus from international media on the fact that the 5 Star Movement has been anti-euro and they may be calling for an exit from the European Union,” Shah said. “What we’ve seen in the last few months is they have backed away quite significantly from that standpoint.”

This outcome remains possible as of Monday morning, depending on how negotiations go. The 5 Star Movement was set to emerge as the biggest party, with around a third of the vote. The populist Lega Nord was expected to come in second, just behind the ruling Democratic Party.

Oxford Economics analysts haven’t been as sanguine as Shah, though they had given no more than a “one in 20 chance of a populist-led coalition government.” The advisory firm’s Jamie Thomson and Nicola Nobile offered this warning in a recent note: “Even an Italian populist government’s failed attempt to ditch the euro
EURUSD, +0.3257%
could bring a halt to not only the ‘euroboom,’ but also the process of U.S. monetary normalization, with the market reaction comparable to the euro-zone debt crisis.”

The best-case scenario for stocks

Traders may put on their rally caps if a grand coalition starts to look likely, but they might have to wait longer for that outcome. “You’re not likely to have that result clear on Monday morning,” Shah said. “Fast-forward two or three weeks, and you get to the point that there is a grand coalition, that is when you would see a relief rally.”

This scenario refers to a broad coalition that involves center-left parties such as Prime Minister Paolo Gentiloni’s Democratic Party, as well as parts of the center-right alliance such as media tycoon Silvio Berlusconi’s Forza Italia party. “It is deemed the most market-friendly outcome, as it would result in the continuation of current policies,” said Dall’Angelo.

Italy’s FTSE MIB has fared better than other European equity
SXXP, -0.82%
in 2018, recently showing a year-to-date drop of less than 1%, while the Stoxx Europe 600 is down 5% for the year. “The outperformance has just been people catching up to, ‘OK, the actual Italian election isn’t as dangerous as had it taken place last year,’” said Shah.

Investors may want to favor Italian stocks that both will weather a shock outcome better than the broad market, and also ought to see gains as the dust settles, wrote UBS analysts in a recent note. The Swiss bank’s analysts recommend Italian companies that aren’t as exposed to the domestic economy, big-cap stocks that are generally more resilient, banks that would benefit from rising interest rates, and companies with strong balance sheets.

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